What’s it: Working capital turnover is a financial ratio to measure how efficiently companies use their working capital to generate revenue. We calculate it by dividing revenue by the average working capital. A higher ratio indicates higher operating efficiency, where every dollar of working capital generates more revenue.
Together with ratios such as inventory turnover, accounts receivable turnover, the working capital turnover ratio is a key metric in working capital management. Management monitors cash flow, current assets, and current liabilities to maintain smooth business operations. Examining them provides insight into how management can improve business operations.
Why is working capital turnover important?
Working capital equals the difference between current assets and current liabilities. Both are on the balance sheet.
If current assets exceed current liabilities, the company has sufficient capital to finance day-to-day operations. In other words, the company’s working capital is positive.
The company uses working capital to support sales and growth. How efficiently the company manages it, we measure it using the working capital turnover ratio.
This ratio connects the company’s funds for operations and its revenue. The higher the revenue generated for every dollar of working capital used, the better.
Ideally, the revenue can be immediately disbursed into cash. So, the company can use it to pay bills, increase working capital, or be invested. Thus, it can increase profitability and support more revenue in the future.
On the other hand, a lack of working capital can cause financial problems. For example, the company has difficulty covering its financial obligations, such as paying suppliers and paying debts due in the near future. Because they do not have sufficient funds, they may be forced to liquidate assets to pay for it all.
How to calculate working capital turnover?
We calculate working capital turnover by dividing revenue by average working capital. Revenue accounts can be found on the top line of the income statement. Meanwhile, the average working capital is calculated by adding up the working capital of the current period with the number in the previous period, divided by 2. The following is the mathematical formula for working capital turnover.
- Working capital turnover = Revenue/Average working capital
Working capital is calculated from the difference between current assets and current liabilities. We can find both on the balance sheet.
- Working capital = Current assets – Current liabilities
For example, a company recorded revenue of $100,000 in 2021. On the balance sheet, the company reports working capital (after calculating it manually) of $30,000 in 2021 and $20,000 in 2020. By inputting the data into the first equation above, we get working capital 4 times ($100,000 / [( $20,000+ $30,000)/2].
How to interpret the working capital turnover ratio?
A higher turnover ratio is generally better. This is because it shows efficient management in managing short-term assets and liabilities. Thus, the company generates higher revenue dollars for each working capital used.
The high ratio has the potential to support the company’s competitive advantage in competing in the industry. Money flows in and out of business smoothly, and the company has more flexibility in its finances.
Higher revenue can be reinvested into the business. Thus, the company has more capital to grow the business and anticipate higher market demand in the future.
In contrast, a low ratio is less favorable. The company manages working capital less efficiently and generates less revenue. The company may overinvest in inventory and face an increase in accounts receivable, which causes an increase in obsolete inventory and an increase in bad debts.
However, interpreting this ratio also does not have to be rigid. We must understand the context and the reasons why this ratio is higher or lower than before. In addition, we also need to compare it with peer companies or industry averages to provide deeper insights.
For example, working capital turnover rose too high. Thus, the company appears to be efficient. But, in fact, the company lacks working capital. And, if market demand remains high, insufficient working capital can cause the company to run out of money to fund its business and not optimize for high sales in the future.
How to improve the working capital turnover ratio?
One way to improve working capital turnover is to shorten the operating cycle. It requires management to improve the conversion of inventory to sales, billing to customers, and payments to suppliers. The shorter the operating cycle, the faster the company can get cash as working capital after paying its short-term bills.
First, the company must increase sales by adopting a more appropriate marketing mix. If successful, the inventory is quickly released and replaced with new ones to meet high sales. In addition to getting revenue faster, the company can also minimize the capital tied up in inventory.
Then, since not all sales are cash-based, some may be credit-based, improving credit policies and collection procedures is another aspect of increasing working capital. If successful, the company could immediately collect money from customers and reinvest it.
Lastly, managing bill payments to suppliers is another way to improve this ratio. For example, management may decide to pay the supplier early to get the discount offered, thus saving more cash. Or, they decide to switch to another supplier which offers more lenient credit terms.
What to read next
- Activity Ratio: Types, Formulas, and Interpretations
- Inventory Turnover Ratio: Formula, Calculation and How to Read It
- Days of Inventory on Hand: Formula and How to Calculate
- Accounts Receivable Turnover: Formula, Calculation, How to Read It
- Days Sales Outstanding: Formula, How to Calculate and Read It
- Accounts Payable Turnover Ratio: How To Calculate And Read It
- Days Payable Outstanding: How to Calculate and Interpret it
- Working Capital Turnover: Formula, Calculation, and Interpretation
- Fixed Assets Turnover Ratio: How to Calculate and Interpret
- Asset Turnover Ratio: Calculation and Interpretation
